Net working capital forms an average of 15 per cent of Indian companies' assets, though this ranges from sector to sector. This article discusses the different working capital cycles for industry sectors and how companies could manage them more successfully.
Current assets in several Indian industrial sectors are an important component of the total asset base. On average, net working capital forms an average of over 15 per cent of the total asset base of Indian companies. While for some companies in the pharmaceutical sector, net working capital is 50 per cent of the total asset base; some companies function consistently on negative working capital. Which companies operate at the extreme ends of working capital and how are the ones in between faring?
To answer this question, we have chosen the companies in the S&P CNX Nifty index, published by India Index Services Ltd (IISL) for the National Stock Exchange (NSE). The index is made up of 50 companies, from which we have removed some companies belonging to specialized industries like banking and software and retained 35 companies that relate mostly to core industries like cement, steel, automobiles, pharmaceuticals and telecommunications. We will concentrate mostly on the best and worst performers1.
Working Capital Cycles
To begin with, we will look at the gross and net working capital cycles of these companies. For the year 2004, the longest gross working capital cycle spans to 571 days and belongs to the Oil and Natural Gas Corporation (ONGC). The next longest cycle belongs to Bharat Heavy Electricals Ltd. (BHEL). Incidentally, both companies are from the public sector and have been listed due to disinvestment by the government.
The companies with the shortest gross working capital cycles are two automobile companies, which are both focused on the two-wheeler segment. Hero Honda Motors Ltd has the shortest gross working capital cycle (23 days) followed by Bajaj Auto Ltd (30 days).
The net working capital cycle also reveals a similar pattern. Four out of the five companies from the automobile industry - which includes companies producing two-wheelers and four-wheelers - have a negative net working capital cycle. Of the four, Tata Motors has the shortest working capital cycle - it has a duration of minus 58 days. These trends have held well with minor changes over the last few years. The gross and net working capital cycles of the five companies in the automobile industry are presented in Figure 1 below.
The pharmaceutical sector is characterized by long working capital cycles. All of the five companies from the pharmaceutical industry (that are part of the 35 companies) studied have net working capital cycles longer than 75 days. The longest is 239 days (Cipla Ltd).
Trying to analyze the working capital position of the companies with the shortest working capital cycles further, we find that these companies have current ratios much lower than the firms with longer cycles. This is in line with what we would expect in such a situation. Firms that are efficient in managing their working capital have, presumably, obtained more credit from their creditors than they have allowed to their debtors. This brought down the duration of their working capital cycles as well as their current ratios. The same is true with quick ratios too (see Figure 3 below).
A similar situation is also found with a few other companies, like Colgate-Palmolive (India), ITC Ltd and Hindustan Lever Ltd (HLL), though no clear trend can be observed in the activities of these companies. While Colgate-Palmolive is a personal care products producer and seller, ITC is the giant of the cigarettes industry and HLL is a diversified firm.
The Magic of Low Inventories
A look into the components of working capital of the companies selected for the study gives more insight into the quality of working capital management of different companies. Among the companies, ONGC is the one which has the maximum accumulation of raw materials - a whopping 532 days, followed by National Aluminum Company (Nalco) with 276 days. In general, we find that the raw material storage periods are higher for the companies in the cement, pharmaceutical and steel industries. This can be attributed to the intensive manufacturing processes involved in these industries, unlike the assembly lines of the automobile industry, which has the lowest raw material storage periods.
We can see from Figure 5 above that the trends explained earlier are consistent over the time period considered. The automobile industry has been having consistently low raw material holding days than the other core industries. If we ignore ONGC and Nalco (which are in oil exploration and aluminum industries and are companies that still belong to, or once belonged to, the public sector) on average, the cement industry appears to have the longest raw material holding periods.
The picture changes a little if we look at the finished goods holding periods of the companies. The cement industry, which is among those that accumulate raw materials the longest, is among the shortest holders of the finished goods. The other industries, more or less, follow the same trend as the raw material, as can be seen in Figure 6 below.
Interestingly, companies from the cement industry, on average, have the lowest finished goods holding periods; and on this count, they are better than the firms in the automobile industry. The superior performance of the cement companies is to a substantial extent related to the seasonality of demand for cement. Traditionally, demand for cement is known to be higher in the third and fourth quarters of the financial year (fourth and first quarters of the calendar year), and taper down towards the onset of the monsoon (around June). As the financial year closes just when demand is normally at its peak, inventories of the finished goods held are likely to be on the lower side.
Indian companies, over the last few years, are also increasingly using supply chain management to control inventories that they hold. Companies in the automobile industry, which outsource the production of most of the components, have obviously benefited more than companies in other industries from such practices. The value of the outsourced components, in the case of Hero Honda, is over 70 per cent of the total costs incurred by the company. Most of the major companies in the automobile industry have also implemented ERP software to manage inventories effectively. Now, dealers just key in their requirements for different models and colors of vehicles that they want in the ERP system and the information is captured by the manufacturer's plant through the Internet. The managers on the shop floor run the program that aggregates the requirements of all the dealers in the country on a regular basis, every Saturday morning, for example. The program generates automatically the units of each model of two-wheeler to be produced on each day of the next production week. It also prints out the bills of material required for the production.
The requirements of the materials and components are transmitted by the ERP system through the Internet to the components producers who are spread out all over the country. All that the component manufacturers have to do is log in and download the volumes demanded from them. When they confirm that they are meeting the requirements, they are instantly given token orders over the Internet. This facilitates integration of their production schedules with the requirements of the automobile manufacturer.
The ERP systems have facilitated the process of receiving the material and movement of the material to the shop floor. The material and components received are inspected and are sent straight away to the shop floor. In the case of Bajaj Auto, which implemented SAP, this reduced the time taken for the process from around five hours to around 25 minutes. With the materials and components arriving in a regular flow, it is no longer necessary to hold more than a few days' requirement in the warehouse.
Magnetizing Debtors, Mesmerizing Creditors
The debtors outstanding periods of the companies in the study revealed a situation that is similar to that of finished goods. While firms in the auto and cement industries have fewer days of their sales locked up in debtors, the figures are much higher for the firms in pharmaceutical and steel industries. The same is the case with the two firms in the electrical equipments industry, which are also part of the set of 35 companies obtained from the Nifty index.
The last of the components of net working capital cycle, namely, the days of outstanding creditors, also follows the expected pattern - the firms from the auto industry have longer creditor periods, which brings down the duration of the net working capital cycle. The other major industries also have outstanding creditors' periods that are quite long too.
The auto industry's firms had the highest outstanding creditors periods up until 2004; since 2004, they have been dominated by cement firms. Apart from this, we also find some strong firms with high outstanding creditors periods among these 35 firms. Consider ITC Ltd, for example, in 2004, its creditors days were a high 229 and records of earlier years are comparable though not the same - 184 days in 2003 and 166 days in 2002. HLL is a similar is the case - its creditors outstanding period in 2004 was 115 days, 112 days in 2003 and 97 days in 2002.
The wide deviations in the creditors position in different industries arises from the fact that in India, the days of credit that is extended and obtained by firms is a subject of negotiation between the suppliers and buyers and changes from industry to industry and from time to time. The penalties for late payment also change based on interest rates and industry norms. Until 2001), the Interest on Delayed Payments to Small Scale and Ancillary Industrial Undertakings Act 1993 was in force. This act was intended to ensure that large firms did not delay payments to small-scale industries. A small-scale undertaking is one in which the investment in fixed assets including plant and machinery, whether owned or leased, does not exceed Rs.4 crore. The act provided for payment of interest on the amount payable to small-scale undertakings, based on the lending rates of banks. These provisions were withdrawn in 2001. Public companies, at present, report the amount outstanding towards small-scale undertakings in their annual reports separate from other payables. Apart from this, there are no laws or regulations that determine the credit terms.
Larger industries have taken the ERP systems to manage the debtors as well as the creditors. Hero Honda implemented the SCM and CRM modules of SAP to connect to suppliers and dealers and manage its transactions with them. To ensure that funds are not locked up in receivables from the dealers, companies also do a regular review of the performance of the dealers. In addition, the stock that is supplied to the dealer depends on the expected demand for the product in the areas served by the dealer, rather than only on the requirement projected by the dealer.
Hero Honda took a step ahead in the implementation of such practices and introduced an interesting mechanism for managing the debtors as well as the creditors. It offered incentives, in the form of rebates in the selling prices, to dealers who pay up promptly. Those who don't pay earlier may either pay on the due date or within 15 days period of grace after that. Those that do not pay within 15 days are fined with a levy of penal interest. On the creditors front, the company set itself a target of paying within 45 days, while the industry average is over 60 days. This has helped them establish good relations with the creditors, as they pay on the 45th day without fail.
Secrets of Success
There are two secrets of successful working capital management:
- Manage inventories efficiently using ERP packages.
- Leverage your brand strength and incentives to induce the debtors to pay up promptly.
It is not easy for firms in all industries to adopt this though or derive quick gains from it. A pharmaceutical company, which produces a few hundred formulations, will find it much more difficult to synchronize its supplies with demand, in view of the sheer number of inputs involved. The retail outlets that interface with the customer are often very small but huge in number, compared to the number of automobile dealers. To derive the benefits of efficient inventory management, such firms might try to establish an ERP interface with the bigger dealers to begin with. The complexity is bound to be enormous for firms but, in spite of all the difficulties, it is worth trying to improve their working capital systems to be more profitable.